Friday, October 3, 2008

A Review of the Emergency Economic Stabilization Act of 2008

The Library of Congress

The U.S. House is expected to vote today on the Senate version of the bailout plan, HR1424, the Emergency Economic Stabilization Act of 2008. Following two weeks of intense scrutiny, debate, political wrangling and even some soul searching, Congress seems ready to pass a bill that offers hope of cutting the Gordian knot strangling credit markets. Action could not come too soon.

The bill, summarized here, has undergone some important changes over the past two weeks and its scope and intent have been clarified. Initially dubbed the "bailout plan" or the "Troubled Asset Rescue Plan," the bill's original intent was to grant sufficient authority to the U.S. Treasury to take steps that would avert panic in the credit markets. The most controversial portion of the plan, would create a:

Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury would be authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to March 14, 2008 - CBO Director Peter Orszag

As Joe Nocera reported Oct. 1 in the New York Times, large investors fearing imminent bank failures were cashing out even very liquid assets and moving them between institutions. Witnessing what appeared to be the first stages of a full-blown run on the banks, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke sounded the alarm, outlined emergency measures, and began to rally the political forces required. The name of the rescue plan was impolitic (why should the Public be troubled about bank assets?), details of the actions required were sketchy, estimates of the cost were imprecise, and oversight measures were missing entirely, but the critical first steps had been taken. The body politic was in motion.

On Monday, 29-Sept-08 the first bill sculpted from the plan, HR3997 (summarized here), failed to pass the House of Representatives, despite the incorporation into the bill of substantial improvements and clarifications to the plan, particularly in the area of oversight. Then, with unusual speed the Senate crafted the new bill, HR1424, adding two unrelated divisions designed to bring more Members of Congress on board. The new Division B, The Energy Improvement and Extension Act of 2008, and Division C, Tax Extensions and Alternative Minimum Tax Relief, would add approximately $112 billion to deficits over the next ten years. More importantly, they provide political cover to Members of Congress who will have to explain to constituents in this month before the election how they could enact an expensive and unpopular bailout plan.

It now seems clear that passage of the bill is necessary, but not sufficient to avoid a major recession. By insuring bank deposits and money market funds up to $250,000 per account, the measure substantially reduces the risk of runs on banks by depositors and will forestall a substantial amount of unproductive movement of deposits from bank to bank and account to account. This insurance provision will also calm investors in those banks.

TARP provides a mechanism for the Treasury to inject capital into financial institutions, transforming unproductive, illiquid assets at participating institutions into cash that can then support new loans.

Investors should watch closely the provisions of the bill relating to
"mark-to-market" accounting requirements, which were instituted earlier this year to provide more transparency to financial reports. The bill would authorize the SEC to restate those requirements and require the Commission to reconsider them and report its findings back to Congress. The practical effect of these provisions will be to improve the balance sheets of financial institutions holding devalued assets, such as mortgage-backed securities, thereby allowing them to make more loans against those assets.

In combination, these provisions are designed to calm investors, create liquidity, and buy time for Treasury to help troubled institutions recapitalize.

The next Administration will have to preside over a period of further consolidation of financial institutions as it tries to keep mounting federal debt from further slowing the economy. It must also address the accounting rules that have confused investors and regulators alike about the underlying values of American assets and corporations.

A detailed analysis of the legal implications of the Act has been provided by the firm of Davis, Polk & Wardwell (available here).

See also previous reports on the bailout bill, including The Bailout Explained by the CBO,
The Case Against the Paulson Plan and Can the Banking System Hold Water?

A collection of posts about the US Economy is maintained here.

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